The Future of Hedge Funds

The unintended consequences could be profound.

Stay Connected

I remember why I wanted to be a trader; I was conditioned to believe the easiest way to make money was to stand near the cash register.

The year was 1991 and capitalism was about to embark on a journey that would morph a standalone free-market into a finance-based, derivative-laced global machination.

Wall Street, unbeknownst at the time, began a transformation that forever altered the DNA of the marketplace. The era of financial engineering took root and large brokers shifted their focus to more propriety revenue streams. As they repackaged and recreated risk, a confluence of regulation and technology enabled mainstream investors to obtain information and executions previously reserved for professionals.

As a young kid with modest means looking for a future, the sexy sirens of Wall Street were intoxicating indeed. After cutting my teeth at Morgan Stanley (MS), I moved to the buy-side and worked at several prominent hedge funds. With years of experience under my belt and tangible validation in the bank, I remember thinking that I had finally arrived; that I finally succeeded.

I chased the cash register until a series of events at the turn of the century shifted my perspective. After grasping at the brass ring for so long, I didn't realize I was lost until I got to where I wanted to be. It was a powerful lesson to absorb but with the benefit of hindsight and the wisdom of experience, everything happened for a reason. See Memoirs of a Minyan.Coming Full Circle

In the early 1970's, the mere mention of Wall Street was taboo at cocktail parties. The more things change, the more they stay the same as Main Street casts blame, in many cases rightfully so.

Several years ago, Minyanville wrote a series of columns questioning the solvency of the world's largest financial institutions. We attracted a lot of attention for asserting those views -- not all of which were particularly pleasant -- but our most ardent fears proved true as the financial crisis erupted with fire and fury. See Will The Banking Industry Survive?

I opined at the time that 50% of the hedge fund universe could disappear. Between the specter of intense regulatory scrutiny, shifting social moods and a market dynamic where rules changed in the middle of the game, money managers -- particularly those tied to "fund of funds" -- operated from a defensive posture. Traditional performance anxiety evolved into a quest for survival, almost overnight. See Martial Law for the Markets.

Remember, in the eyes of both the government and Main Street, hedge funds are an acceptable casualty of war. The perfect storm of 2008 expedited that mindset, as did the societal acrimony following the Bernie Madoff scandal. The alleged insider-trading ring recently uncovered only serves to add to the insecurity and anger currently surrounding this embattled industry. For more see Kevin Depew's video, The Insider Trading Debate.

Outcomes and Unintended Consequences

Typical hedge fund terms are "one and twenty," or 1% management fee and 20% performance fee. I expect the industry standard to shift to three-year aggregate capital retention that eliminates annual payouts (high-water marks) and more closely ties compensation to performance. See more in the video, What's Ahead for Hedge Funds?

The old guard -- those I grew up with in the industry and yes, some of whom I looked up to -- is rapidly changing. Some have made a conscious choice to leave, as they no longer feel there's economic incentive to compete. Others have left as a function of need, not having been able to keep up with the ever-changing quasi-socialist construct.

While some will argue they got what they deserved, I'll humbly offer the unintended consequences will be profound. Over the last few years, hedge funds have assumed many of the traditional responsibilities of market intermediaries. By squeezing them from existence, an integral layer of liquidity is being removed from the marketplace.

There's a ton of anger aimed at hedge funds and some of it is certainly warranted. I would also argue that the lens of culpability extends from consumers who over-extended on their credit to firms that financially engineered the markets to policymakers complicit by acceptance to the CEO of the United States of America.

They say the opposite of love isn't hate; it's apathy. If that proves true, this financial crisis has a ways to go. As lynch mobs gather and politicians point fingers, I can't help wonder if we'll look back at this historically significant juncture and say that when it came to hedge funds, we should have been careful for what we wished.